McCotter Trailblazes Social Security Prosperity

Peter Ferrara

10/13/2011 12:01:00 AM - Peter Ferrara

On September 12, the pioneering Rep. Thaddeus McCotter introduced trailblazing legislation
providing workers the freedom to choose personal savings and investment accounts to finance
half of their future Social Security benefits. This legislation would completely solve the future
Social Security financing problem, without cutting benefits or raising taxes, as officially scored
by the Chief Actuary of Social Security.

Indeed, because standard, long-term market investment returns are so much higher than what
Social Security even promises, workers with personal accounts will enjoy higher rather than
lower benefits. Moreover, the legislation would result in the greatest reduction in government
spending in world history, as explained below.

Why Social Security Is Fundamentally Broken

Next year the Baby Boom begins to retire on Medicare in earnest, and the year after that on
Social Security. For decades now, the federal government's own official reports have been
showing that Social Security would not be able to pay all promised benefits to the baby boom
without dramatic, unsustainable tax increases.

Last year, Social Security began running a cash deficit, for the first time since President
Reagan saved the program in 1983. Under what the government's actuaries call intermediate
assumptions, those deficits will continue until the Social Security trust funds run out of funds
to pay promised benefits by 2037. After that, paying all promised Social Security and Medicare
benefits financed by the payroll tax will require eventually almost doubling that tax from 15.3
percent today to nearly 30 percent.

Under what the government's actuaries call pessimistic assumptions, the Social Security trust
funds will run out of funds to pay promised benefits by 2029. After that, paying all promised
benefits to today's young workers would eventually require raising the total payroll tax rate to 44
percent, three times current levels, and ultimately more.

Social Security operates as a pure tax and redistribution system, with no real savings and
investment anywhere. Even when it was running annual surpluses, close to 90 percent of the
money coming in was paid out within the year to pay current benefits. Even the remaining
annual surpluses were not saved and invested. They were lent to the federal government and
spent on other government programs, from foreign aid to bridges to nowhere. The Social
Security trust funds received back in return only internal federal IOUs promising to pay the
money back when it is needed to pay benefits. Those federal IOUs are rightly accounted for
in federal finances not as assets but as part of the Gross Federal Debt, subject to the national
debt limit. That is because they do not represent savings and investment but actually additional
liabilities of federal taxpayers.

Consequently, when Social Security runs cash flow deficits, which it will until the trust funds
run out around 2030-2035, those deficits represent immediate new burdens on taxpayers. Social
Security then returns some of its trust fund bonds to the federal government, asking for the cash
to cover the deficits to pay all promised benefits. But since the trust fund bonds do not involve
any real assets that can be used to pay back Social Security for the past borrowed funds, the
government can only cash out the bonds by raising taxes, in addition to all the payroll taxes
workers and their employers will have to continue to pay, or by issuing new federal bonds to the
public, increasing the national debt burden on the public and the economy further.

In my recent book, America's Ticking Bankruptcy Bomb

, I calculate that the increased taxes
between now and when the trust funds run out would amount to $7 trillion, again on top of the
continuing payroll taxes. Or the national debt held by the public would have to increase by $7
trillion, more than 50% above current levels.

Social Security's pay-as-you-go tax and redistribution system does not earn the investment
returns that a fully funded savings and investment system would. As a result, over the long run
the system can only pay low, inadequate, below market returns and benefits. That is why studies
show that for most young workers today, even if Social Security does somehow pay all its
promised benefits, those benefits would represent a real rate of return of around 1 percent to 1.5
percent or less. For many, the real effective return would be zero or even negative. A negative
rate of return is like putting your money in the bank, but instead of earning interest on it, you
have to pay the bank for keeping your deposit there. That is effectively what Social Security is
for many people today.

Moreover, on our present course, that is what Social Security will be for everyone in the future.
Whether the long-term deficit is closed ultimately by raising taxes or cutting benefits, that will
mean the effective rate of return from the program will be lower, ultimately falling into the
negative range for everyone.

McCotter's Solution

McCotter's bill provides a complete solution to these problems, benefiting both future seniors
and taxpayers, based on proven reforms that have already worked in the real world. The bill
empowers each worker age 50 and below with the freedom to choose a contribution to a personal
savings and investment account equal roughly to half of the employee share of the Social
Security payroll tax.

One important innovation in McCotter's bill is that instead of financing the contribution from
Social Security payroll taxes, with general revenues paid into Social Security to maintain
continued payment of current Social Security benefits, the contribution would be financed out
of general revenues directly, with no reduction in the payroll tax revenues flowing into Social
Security. That avoids AARP's chief past criticism of personal accounts, that they would drain
from the program the payroll taxes needed to pay for today's benefits, even though AARP has
not raised a peep about Obama's temporary payroll tax cuts, which Obama has proposed to
extend and expand for next year.

Moreover, under McCotter's bill, the general revenue contributions to the accounts are financed
by reductions in other government spending. The bill provides that the accounts are to be
financed only out of a Spending Reduction Account reflecting spending reductions already
enacted. That will primarily involve block granting dozens of federal means-tested welfare
programs back to the states, modeled on the enormously successful 1996 reforms of the old
AFDC program, with further legislation now being drafted to provide for that.

Ultimately, as workers retire in the future relying on the personal accounts to finance the
majority of their retirement benefits instead of the government, that will create enormous
surpluses in Social Security. Under current law, those surpluses would flow back into general
revenues, providing enough funding itself to cover all future personal account contributions to
Social Security.

No change would be made in any way for those already retired today, or those anywhere
near retirement. Each worker would be perfectly free to choose to stay with Social Security
as is and forego the personal accounts entirely. There would be no change in Social Security
benefits under current law for those who make this choice. But the Chief Actuary concluded that
McCotter's accounts are so beneficial to workers that 100 percent of workers would choose the
accounts.

The workers who do choose the personal accounts, however, would invest their funds by
choosing from a range of privately managed investment funds, just as with the Federal Thrift
Savings Plan for federal employees, or the Social Security personal account system adopted
30 years ago in Chile that has operated with such great success for the workers of that nation.
Nearly 100 percent of workers chose the personal accounts in Chile, validating the Chief
Actuary's judgment regarding the McCotter accounts.

To the extent a worker chooses the personal account option over his career, the personal account
would finance an equivalent percentage of the worker's future Social Security retirement
benefits. For a worker who exercises the account for his entire career, the account would finance
the maximum of 50% of the worker's retirement benefits. For those who exercise the account
option for fewer years and later in their careers, the account would finance proportionally less
under a statutory formula. But the personal accounts will pay more than the amount of Social
Security benefits they replace, leaving the retiree with higher benefits overall on net. There
would be no change in Social Security survivors or disability benefits due to the McCotter
accounts.

Workers who choose the personal accounts are backed by a federal guarantee that they will
receive at least as much as promised by Social Security under current law, maintaining the social
safety net of the current program. That is similar to the guarantee backing the personal accounts
in Chile. That is workable because standard, long-term, market investment returns are so much
higher than what completely non-invested, purely redistributive Social Security promises, that it
is extremely unlikely after a lifetime of investment that the personal accounts will not be able to
pay at least that much.

The bill was officially scored by the Chief Actuary of Social Security, with his scoring
memorandum available on the Social Security Administration website. The Chief Actuary scores
the bill as eliminating all future deficits of Social Security, with no benefit cuts or tax increases,
assuring that all Social Security benefits will be paid. That is because the personal accounts
finance so much of the future benefits of Social Security that future deficits between continuing
payroll tax revenues and continuing benefit obligations of the program are eliminated entirely.
The accounts are so powerful that they eliminate the future deficits in the disability portion of
Social Security as well, even though no changes are made to disability benefits.

As a result, McCotter's bill involves no change in the Social Security retirement age, cuts in the
Social Security COLA, or other benefit cuts promoted by other proposals. Workers with personal
accounts choose their own retirement age themselves, rather than the government choosing
for them, with the incentive to delay retirement to the extent feasible to allow further account
accumulations. Some workers with mostly intellectual jobs may delay retirement well into their
70s, which could never be imposed politically otherwise. Other workers with more physically
demanding jobs would still be perfectly free to retire in their early 60s.

Because long-term market investment returns are so much higher than what Social Security even
promises, let alone what it can pay, future retirees will actually enjoy higher benefits with the
personal accounts. With those returns accumulating over a lifetime, the personal accounts will
finance higher benefits than the Social Security benefits they replace under McCotter's bill.

The bill involves the greatest reduction in government spending in world history, as the personal
accounts take over the responsibility for financing through private personal savings and
investment $8.555 trillion in future Social Security benefits, as scored by the Chief Actuary of
Social Security. As a result, the Chief Actuary's score indicates that the bill eliminates entirely
the unfunded liability of Social Security. Moreover, based on the Chief Actuary's score, the
spending reductions to finance the accounts will add up to a minimum of another $3.75 trillion
in savings, bringing the total reduced spending under the bill at a minimum to over $12 trillion.
But block granting all remaining federal, means-tested welfare programs back to the states would
likely save far more in future years than the $3.75 trillion needed to finance the transition to the
personal accounts.

With the transition to the accounts funded by reduced government spending, there would be no
transition debt at all. That means all of the savings and investment in the accounts would flow
directly into the economy in full, boosting jobs, wages and economic growth today.

Personal Accounts and the Financial Crisis

But didn't the financial crisis prove that such personal savings and investment for retirement
is a bad idea, as President Obama claims, mocking the idea of personal accounts? To counter
that criticism, I performed a study with William G. Shipman, former principal with State Street
Global Advisors, perhaps the largest private pension investment management firm in the world.
Our results were published in the Wall Street Journal in October, 2010.

We examined the case of a hypothetical senior retiring at the end of 2009 at age 66, who had the
freedom to choose personal accounts when he entered the work force back in 1965 at the age of
21. Paying what he and his employer would otherwise pay into Social Security into the personal
account instead, he was fool enough to invest his entire portfolio in the stock market for his 45-
year working career. How would he have fared in the financial crisis, as compared to Social
Security?

Let's call our hypothetical worker Joe the Plumber. While working, he earned the average
income each year for full-time male workers. His wife Mary, same age, also earned the average
income each year for full-time females. She invested in the same personal account with Joe, an
indexed portfolio of 90 percent large-cap stocks and 10 percent small-cap stocks, earning the
exact returns reported each year since 1965.

This average income couple would have reached retirement at the end of 2009 with accumulated
account funds, after administrative costs, of $855,175, almost millionaires. Indeed, they were
millionaires, but the financial crisis lost them 37 percent of their account funds the year before
they retired. This can be considered effectively a worst-case scenario, as the couple retired just
one year after the worst 10-year stock market performance in American history, from 1999 to
2008.

Yet, their account would still be sufficient to pay them about 75 percent more than Social
Security promises them, increased annually for inflation just like Social Security. This assumes
that in retirement the couple switches to a lower-risk, conservative portfolio of government and
high-grade corporate bonds earning on average a real return of just 3 percent.

These calculations are consistent with the experience of the already existing, real world versions
of personal accounts. Chile's personal account system survived the financial crisis with no
bankruptcies in the personal account investment fund. Indeed, not even a dollar had to be paid
out on the guarantee backing the accounts, as the lifetime of savings and investment in the
accounts still provided benefits greatly exceeding what the old system even promised.

Local government workers in and around Galveston, Texas, also chose a personal account
system to replace Social Security entirely 30 years ago, when that was still allowed for state and
local government workers. Returns on the accounts declined for a couple of years during the
financial crisis, but no one lost their retirement funds, with all still enjoying much higher benefits
than Social Security. Similarly, the personal accounts enjoyed by federal workers in the federal
Thrift Savings Plan (TSP) suffered declining returns for a couple of years, but the accounts have
since recovered those losses, as documented on the website of the TSP.

In my book America's Ticking Bankruptcy Bomb, I argue that by modernizing our old-fashioned,
tax and redistribution entitlement programs to rely on 21st century capital, labor, and insurance
markets instead, we can achieve all of the social goals of these entitlement programs far more
effectively, serving seniors and the poor far better, at just a fraction of the current cost of those
programs. Rep. McCotter's bill is a demonstration of that.